Why India is not ready for the OECD

"We'll be very honoured [if India decided to join the OECD] but it's up to them to start the process. We have made clear to Indian authorities that they can start the process," the secretary-general of the OECD, Angel Gurria, told delegates, including the Indian finance minister, Pranab Mukherjee, at a seminar in Delhi in June.

The OECD and India have been working together for 16 years. In May 2007, the OECD Council adopted a resolution to strengthen the cooperation with the country through a programme of enhanced engagement.

"Our engagement with India is with same rigour as would be with any member country," said Gurria, who attended the two-day seminar jointly organised by the finance ministry and OECD.

The OECD released a survey on the same day that said India could potentially step up to a 10% growth rate year-on-year over the next five years, but urged more fiscal reforms, increased infrastructure investment and a relaxation of labour laws.

And it is these reforms and policy changes that India must implement if it can realistically consider itself – and be considered by the OECD – for full membership. Tax is going to be integral to India pushing towards joining the other 34 members in the organisation.

But is India's tax system for membership? For a long time now, certain aspects of the tax system have broadly followed OECD guidelines such in transfer pricing, but this and other aspects are short of their standards and would need drastic attention if membership beckoned.

These issues revolve around five key areas: transfer pricing, permanent establishment, foreign direct investment, direct tax, and service fees and royalties.

Views from India’s tax professionals

"I do not see any tangible benefits of joining. We are too big to need to be involved in the OECD." Pranay Bhatia, partner at Economic Laws Practice "India will eventually join, I am sure. But I don't think it will happen until China becomes a full member." Samir Gandhi, head of Deloitte India's transfer pricing team "I think the government needs to decide on what the shape of the DTC before it can even consider looking into joining." Nikhil Mehta, of Amarchand & Mangaldas and Gray's Inn Tax Chambers, London "If India joins then litigation should decrease. The Indian definition of PE and technical services are very wide and so joining would narrow this and reduce the number of disputes. The big advantage is that it would bring in global models to India and that would only make my life easier." Bela Seth Mao, head of India tax at Shell "I am not paying much attention to this at the moment. However, I am in favour of India, but a lot of industry consultation is required." Sunil Kumar Dhareshwar, vice president, taxation, Asia, News Corporation

Indian transfer pricing rules are broadly based on OECD guidelines, with some deviations, and over the years, courts in India have acknowledged the relevance of the OECD guidelines while interpreting Indian rules.

The only changes that would need to be made would be the adoption of multiple year data instead of single year data for comparability analysis and the use of the inter-quartile range and median, instead of arithmetic mean.

As reported in the last issue of India Quarterly, Indian transfer pricing regulations are unique in the sense they require the computation of a single arm's-length price, through the mean of comparables, instead of a range.

The big-four accountancy firms made initial representations to the government concerning aspects of the country's transfer pricing rules in December 2010.

The contents of their report focused on a petition for multiple-year data and the introduction of the inter-quartile range.

The high number of adjustments and consequent litigation would be dramatically reduced, taxpayers and advisers believe, if the government were to adopt the inter-quartile range, even if they kept the single-year data requirement.

However, taxpayers and advisers have failed to convince the authorities of their case. In fact, the complete disregard for their arguments supporting the inter-quartile range have frustrated tax professionals who feel the system is in place for revenue reasons and that the government is not thinking about the goal of reducing the high level of litigation.

Despite this disagreement, the government is supportive of the OECD guidelines and regularly consults on international standards when applying the rules. Membership would likely see the issue of the inter-quartile range disappear.

Ready for the OECD: Yes

Taxpayers inside and outside India know that the country's definition of permanent establishment (PE) is an area that needs to be addressed. High volumes of disputes and litigation has stemmed from the authorities, often misleading and varying, interpretations of what a PE is.

"The Indian definition of PE is very wide and so joining would narrow this," said Bela Seth Mao, head of India tax at Shell.

There are three main differences between the way India interprets PEs and that of the OECD:

• Agency PE provisions are more stringent in Indian treaties. In India the securing of contracts triggers PE, as opposed to the concluding of contracts under OECD model.

• The stocking and delivery of goods by foreign company creates a PE under the majority of Indian treaties, while it is exempt from PE threshold under the OECD model.

• Some of India's tax treaties include the concept of a service PE. This is absent in the OECD model.

India is also one of a small number of member and non-member nations of the OECD that does not agree with any of the clarifications given by the OECD in the 2010 update of the Model Tax Convention.

"The stance of India, being represented by the revenue authorities, completely defies logic," says Rahul Mitra of PwC.

The whole concept of a PE, particularly fixed place of business PE, is that an enterprise should have a fixed place of business in a country, which needs to be at its disposal.

And India is the only country among all the observer nations, to expressly state that it does not agree with the approach to attribution of profits to PEs in general that is reflected in the revised convention on article 7 (attribution of profits) and also in the revised commentary to article 7.

It is this express resistance of the Indian revenue to the OECD's approach on attribution of profits to PE in general, that appears to be rather disturbing and failing in rationale.

"One fails to fathom the exact grievance of the Indian revenue in this regard," said Mitra.

Ready for the OECD: No

Mukesh Butani, Chairman, BMR Advisors – Taxand

Whether India should join the OECD or not is for the policy makers to recommend and politicians to give stamp of approval. I think India’s decision to join the OECD would depend on several aspects including broader trade and investment and beyond the realm of taxation. There are clear advantages for India to consider OECD membership as it would be seen as playing an important role in the policy development. Though OECD guidance is not binding on member states, India by becoming a member shall seriously relook at aligning itself to some extent. In addition, India has been playing a material role as an observer ad has actively participated in the deliberations on several important subjects, most recent being India’s comments on the 2009 OECD Model Tax Convention. Clearly, India sees itself at variance to most OECD member views on the model convention. Whereas, India may have a point of view different than others, by being an OECD member, it would enable India to reconcile its view and come to a common understanding with majority of the members. This could go a long way in resolution of international tax disputes which have been on the rise in the past few years.

Economics may be another reason why India may not be ready for OECD membership. Any OECD member country has to adhere to the articles 2 and 3 of the OECD Model Tax Convention and has an obligation to make its economy open for free flow of capital form the other OECD members.

But India has not yet permitted full foreign direct investment (FDI) in the retail and insurance sectors. Something as simple as this is enough to hold up discussions on membership. And this stance is unlikely to change soon as some Indian political parties oppose full FDI in both these sectors.

However, there are grounds for cautious optimism as the government has shown that is takes this topic seriously and considers the views of the OECD as relevant.

A 2009 report by the OECD said that India needs to strengthen and liberalise its regulatory framework and invest more in infrastructure to attract increased FDI.

The OECD's 2009 Investment Policy Review of India said India has designed policies to encourage investment as part of market-oriented reforms since 1991 that have paved the way for improved prosperity.

"Restrictions on large-scale investment have been greatly relaxed. Many sectors formerly reserved to the public sector have been opened up to private enterprise. Import substitution and protectionism have been replaced by an open trade regime," the report notes.

But further reforms are needed. India's policy framework for FDI still remains restrictive compared with most OECD countries. Meanwhile, its investment needs remain massive, with poor infrastructure holding back improvements in both living conditions and productivity.

"India's FDI performance and progress in the past year has been particularly strong, even in a very tough global environment," said Gurria. "This is a vote of confidence in India."

But more needs to be done so that all of India benefits from needed investments. "One of the major challenges facing India is to take advantage of economic growth to reduce the gap between rich and poor," Gurría said. "While national economic growth has been impressive, the gap between the richer and poorer Indian states has widened. This trend needs to be reversed through measures at both the national and state level."

Ready for the OECD: No

Ajit Korde, India’s Settlement Commission

In my view, India’s decision of joining the OECD in the near future or at the later stage would depend on the non-tax considerations. If only tax considerations are taken in to account, India’s joining OECD will help India a great deal mainly because the OECD consists of developed countries and India is gradually becoming one. A country’s tax laws also reflect their state of economy and hence tax experience of the developed member countries of the OECD and the OECD would help India in tax legislation, administration and tax research. Most important of all, it will help align Indian international tax laws and direct tax laws with the international standards bringing about uniformity and desirable certainty for all the stakeholders. However, the OECD’s tax work is more suited to the developed countries requirements as OECD carries out work for the requirements of its member countries. Therefore, India’s association with the OECD will require changes to some of the Indian law unsettling some of the settled issues For example, India has number of disputes on fees for technical services and some of the concepts on it are settled now. However, economically India may not be ready for the OECD membership. An OECD member country has to adhere with the article 2 and 3 of the OECD Model Tax Convention and has an obligation to make its economy open for the free flow of capital from the other OECD members. The Indian economy has not yet attained that stage as the government has not made full capital account convertibility. Besides this factor, many of the economic issues acquire political colour in democratic country for example India has not yet permitted full FDI in the retail sector or insurance sector. In both these sectors full FDIs is opposed by some of the Indian political parties also. Therefore, unless the OECD addresses Indian concerns on the requirements of the Indian economy, I do not foresee India becoming an OECD member in the near future as every nation’s policy and decisions are dictated by its self-interest.

On August 12 2009, the government released a draft of the Direct Taxes Code (DTC). This 256-page document ripped up the country's 48-year-old tax law and was the first draft law to be made available to the public for consultation. The stated objective of the draft legislation was to establish an economically efficient, effective and equitable direct tax system which will facilitate voluntary compliance and reduce the scope for disputes and need for complex law.

Fast forward two years and the DTC is in a different shape to the first draft. Taxpayers are awaiting anxiously the final version of the law before it becomes effective on April 1 2012. The code now includes measures such general anti-avoidance rules, controlled-foreign company provisions as well as the introduction of the concept of place of effective management. The code also clarifies the issue of indirect and direct transfers – a topic that is central to the Vodafone dispute.

By modernising the country's tax law, India will boast a clearer and simpler system. The previous direct tax legislation went through more than 1,000 amendments in its lifetime and had become burdensome to taxpayers and advisers.

The OECD states that the main objective of a tax system is to promote economic efficiency, equity and enforceability. Given these objectives, India seems well placed to ensure its direct tax system is OECD-compatible.

Ready for the OECD: Yes

India's tax treaties permit both the resident state and the source state to tax royalties, meaning that they depart from the principle of the exclusive right of the resident state to tax provided for in the OECD Model Tax Convention. However, most of the treaties generally adopt the OECD definition of royalties, except where the definition in a number of them also includes consideration for the use of industrial, commercial or scientific equipment.

The source country taxation right in India's tax treaties extends even to technical service fees, which under the convention would be dealt with as business profits.

There is no specific article dealing with fees for technical services in the OECD convention. Hence such fees could be subjected to tax in the source country only if the recipient has a PE, for example, a branch, in the source country.

However, India's tax treaties generally contain an article dealing with fees for technical services or an article dealing with royalties as well as fees for technical services. This article gives taxing rights to the source country as well.

For royalties, the 2008 Model Tax Convention update included several amendments to the commentary with the aim of clarifying a number of issues relating to classification of intangible transactions. India has reserved its position on these amendments as it believes that some of the payments may constitute royalties.

Ready for the OECD: No

Though it would seem that this analysis would suggest that India is only marginally short of being ready to join the OECD, there is another factor which must be considered: the political will of India to join.

On June 13, the OECD and India announced plans to strengthen co-operation on tax-related issues through the development of a three-year partnership that will provide greater opportunities for structured dialogue and information sharing.

The partnership will build on existing engagements and further enhance Indian participation in the OECD's global initiatives.

The three-year programme will broaden existing technical cooperation on tax matters and extend high-level policy dialogue between India, other emerging countries and the OECD. It will also deepen India's work within the OECD Committee on Fiscal Affairs and its subsidiary bodies, towards the eventual goal of becoming a full participant in the committee.

The programme will cover a range of issues over the next three years, including improving tax administration, adapting transfer pricing and tax treaty rules to the new international environment and better understanding the links between illicit flows and tax evasion. It will also enable India to contribute to OECD work on tax and inequality, on the application of VAT/GST to cross-border services and on aggressive tax planning and harmful tax practices.

This crackdown on illicit flows and tax evasion could be the catalyst to India becoming a full member. This three-year period should be seen as a trial-run. Depending on how much money is raised through this clampdown, the Indian government should have a better idea in 2014 whether being an OECD member has its benefits. Time will tell, but if the government see increased trade and greater revenue generation from being a member, then the challenges of the country's tax system will likely be overcome sooner rather than later.

India’s enhanced relationship

India's involvement with the OECD is technically known as enhanced engagement. Enhanced engagement is a fundamental proposal by the OECD countries to forge a more structured and coherent partnership, based on mutual interest, with five major economies: Brazil, China, India, Indonesia and South Africa. In joining OECD countries in this initiative, the countries participating in this programme, the OECD states, are adding their "considerable weight to the global effort to build a stronger, cleaner and fairer global economy". A central element of the programme is the promotion of direct and active participation of these countries in the work of substantive bodies of the organisation. Each country participates in OECD work through a programme containing a mix of several elements, notably: Participation in OECD committees, Regular economic surveys, Adherence to OECD instruments Integration into OECD statistical reporting and information systems, Policy-specific peer reviews. The actual mix and the sequencing of the elements are determined by mutual interest. While enhanced engagement programmes are distinct from accession to the OECD, they have the potential in the longer term to lead to membership of the organisation, should the participating countries decide to explore that possibility. Source: www.oecd.org

The view from the Supreme Court

Mohan Parasaran, Senior Advocate, Supreme Court of India and Additional Solicitor General of India outlines his thoughts on India’s potential membership. International Tax Review: What is the Indian government's position on joining the OECD? Mohan Parasaran: Representatives from various levels of the authorities of the Central Board of Direct Taxes, officers of the income tax department as well as in the Ministry of Finance are participating in various programmes organised by the OECD in India and outside India which indicates a gradual inclination of the government to join OECD. At present, the government has initiated several steps to check tax evasion and trace back black money from foreign shores. Therefore, joining OECD would greatly advance this objective. ITR: Does India need to join? Parasaran: Although India could benefit immensely as an OECD member in its efforts to check tax evasion, it is also conscious of conceptual differences and key underpinnings, which form the basis of the two systems. For instance, the OECD predominantly supports a residence basis taxation system, while India's tax treaties are based on a combination of OECD and UN model conventions with a higher emphasis on source country taxation. This is reflected in most of India's tax treaties, which provide for source-country taxation of passive incomes such as dividends, interests, royalties and capital gains. There are several key areas which India will need to revise its understanding if it were to become an OECD member such as in the place of effective management rule in determining residency and the differences in understanding of fixed place permanent establishments. ITR: What does India have to be to become a full member? Are there any obstacles? Parasaran: As discussed earlier, there are some fundamental differences in key underpinnings of the tax system, which India follows and the one which the OECD prescribes. That apart, for instance, if India were to become an OECD member, it would have to abide by several agreements and codes of conduct for the management of a market economy. The OECD rules on private investment may not be entirely favourable to India at this moment. Also, symbolically, OECD membership places India in the elite category of the developed country club and in my opinion, India will be conscious of this while taking a call on the membership issue given its history of being at the helm of espousing causes on behalf of the developing/under developed countries. Further, India's responses to any initiative before any international forum would naturally reflect its social, economic and political conflicts thereby rendering its responses to be naturally slow and cautious. ITR: What would be the benefits and negatives for taxpayers if India joined? Parasaran: The list of both may be a long one. The expertise of OECD in the management of economies of various countries would be a positive contributing factor. How far, India would be able to translate these inputs given its various constraints and restraints, may be a moot question. In the light of the efforts made at the OECD platform implying a systemic integration and seeking to establish an international tax policy framework involving all countries across globe, India's stance on relying on the Model Tax Convention, commentaries and updates thereof ought to be taken as seeking to break the barriers and hailing the move towards a global international tax policy framework within its given domestic policies. ITR: What would India's tax system look like if it was to join tomorrow? Parasaran: India's approach for the administration of direct tax system would be a dampening factor. The approach in place appears quite narrow and ring-fenced in so far as international taxation is concerned. Therefore, for a better understanding of the processes that can lead towards a path of a more informed policy analysis, the OECD can be an efficacious mechanism as it accommodates the interests of the most advanced industrial economies and their taxpayers without correspondingly imposing any binding rules on the tax policy of countries, whether they are members or not. The OECD has sought extensive participation from many developing countries resulting in the emergence of a holistic picture to appreciate the realities. How far India's tax authorities would wish to make a compromise is to be seen only in the future in view of very many complexities which exist as of today.